There's A Revolution Coming In Global Finance

HONG KONG – In March 2011, the catastrophic earthquake, tsunami, and nuclear disaster that hit Japan halted production of key components on which many global supply chains depend. The sudden disruption of these essential materials from the production process forced a reassessment of how these supply chains function. But such vulnerabilities are not confined to the manufacturing sector. The finance industry, too, has suffered its own near “supply chain” meltdown in recent times.

The failure of Lehman Brothers in 2008 not only roiled global financial markets, but also brought global trade practically to a standstill as wholesale banks refused to fund each other for fear of counter-party failure. The simple banking system of the past, one based on retail savings being concentrated in order to fund the credit needs of borrowers, had evolved into a highly complex – and global – supply chain with knock-on risks of disruption comparable to those seen in Japan last spring.

Financial supply chains and those in the manufacturing sector share three key features – architecture, feedback mechanisms, and processes – and their robustness and efficiency depend upon how these components interact.

In today’s financial architecture, as with other supply chains, interdependent networks tend to concentrate in powerful hubs. For example, just two financial centers, London and New York, dominate international finance, and only 22 players conduct 90% of all global foreign-exchange trading. Such concentration is very efficient, but it also contributes to greater systemic risks, because, if the leading hubs fail, the whole system can collapse.

Open feedback mechanisms ensure a supply chain’s ability to respond to a changing environment, but, in the case of financial supply chains, feedback mechanisms can amplify shocks until the whole system blows up. The Lehman Brothers collapse triggered just such an explosion, with the financial system saved only by government bailouts.

Finally, the processes within supply chains, and the feedback interactions between them, can make the system greater or smaller than the sum of its parts. Since a complex network comprises linkages between many sub-networks, individual inefficiencies or weaknesses can have an impact on the viability of the whole.

Like manufacturing supply chains in the wake of the Japanese disruption, financial supply chains face formidable pressures to re-engineer and adapt as the global economic balance shifts towards emerging markets. As that happens, billions of consumers will enter these countries’ middle classes, new social networks will evolve, and climate change will become a growing factor in global commerce.

In addition, major regulatory reforms will impose new and higher costs on the financial sector. Banks and other institutions are also under pressure to devise new financial products that can help the real sector to manage more complex risks and enable investment in areas such as green technology and infrastructure for developing economies.

Moreover, global financial stability now depends upon greater cooperation at the international level, with tighter enforcement of rules at the national level. It is also clear that emerging markets are searching for alternative growth models that are green and sustainable. Their financial sectors will have to operate very differently from the current model, which is driven by consumption.

In a world in which both consumption and finance must grow more slowly to cope with global resource and environmental constraints, what role can finance play in reducing addictive consumption, funded by unsustainable leverage? And, given that financial institutions will have to monitor and manage risk in a radically different manner, both for themselves and their customers, what is the role of distribution in a world where consumption, savings, and investment will accelerate in volatility?

Financial “production” is currently a top-down process. Instruments are designed in such a way that their sales generate more profits for financial engineers than for end users. But the rise of interactive social networking has made financial innovation more bottom-up. Millions of bank customers using mobile phones can provide immediate feedback on which products and services they like or dislike. In the future, client-service and transaction-management systems will receive more input from customers more frequently, so that product design is shaped interactively.

The current strategy in the financial sector drives excessive competition by increasing market share at rivals’ expense, often breaking trust with customers for the sake of short-term gains. Yet the financial sector has, in previous eras, proven that it can operate as a public good by providing trustworthy, efficient services. The winning financial supply chains of the future will instill confidence that they offer safe, stable, and efficient services to the most clients.

Innovation in the last century focused on processes, products, and services. Today, the financial sector needs innovation of a higher order, involving business models, strategy, and management approaches that restore trust in finance. Just as Steve Jobs of Apple transformed the computer industry through lifestyle products and highly reliable, user-friendly, and “cool” services, financial institutions will have to introduce new value chains that create confidence by adapting to the growing needs of new markets.

Given such profound changes, financial leaders should think about how to orchestrate a new financial supply chain – the “killer app” for our still new century.

Andrew Sheng, President of the Fung Global Institute, Hong Kong, and the Chief Adviser to the China Banking Regulatory Commission, is a former Chairman of the Securities andFutures Commission of Hong Kong.